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Understanding Cash Flow in Residential Real Estate

The Importance of Cash Flow

Let’s learn about Cash Flow and how it relates to analyzing the purchase of residential real estate. What is it? How do you calculate it? Why is it so important?

When it comes to building wealth, there are numerous ways to measure the viability of different investment vehicles. Cash flow is one of the most popular ways to do that for real estate.

What Is Cash Flow?

In its most basic form, it refers to the money you get to keep in your bank account after paying every bill associated with your rental property.

Income – Expenses = Cash Flow 

To best illustrate each word, we will analyze a property and determine whether it has cash flows.

Consider All Sources of Income

Income refers to all the money you take in. Depending on the type of property you own, income sources can vary. In most single-family rentals, income is generally the rent you charge your tenant.

You might have some more options in a 2-4 unit type of property, like a duplex, triplex, or fourplex. For example, in some areas of downtown Nampa, you will find some properties that were initially single-family homes but have now been split or converted into more than one residence.

In these types of properties, you may only have one garage. Who gets the garage? Well, if it’s a detached garage, whoever wants to pay for it would.

Source: intermountainmls.com

Right? It’s common for apartment complexes in this area to charge anywhere from $50-70 per garage. Some will also charge you for any extra covered parking. Another way to look at this garage is rentable storage. A 10×15 storage unit costs about $150/mo.

What about laundry? There are no laundry facilities in your typical fourplex. What if you put a washer and dryer in the garage and make them coin-operated? It would save your tenants from having to leave the property for laundry and put a little extra into your income column. We found that, on average, it costs about $6.20 to wash and dry one load at local laundromats, and most families do about 6-8 loads per week.

Expenses Must be Carefully Evaluated

Let’s move on to the second part of that equation: expenses. Expenses should include everything you have to pay for that property, whether you do it regularly or not. People usually botch up the calculations because they forget to account for ALL expenses. On some properties, even $50/month that you didn’t plan for can make the difference between a good investment and a possible mess.

Debt Payments

The first thing you should always account for is debt. What do you owe on this property? Do you have a mortgage? In most cases, you do. Your mortgage payment often includes the principal, interest, property taxes, and insurance (PITI).

Operating Costs

You also have costs to run the property. Most of these things you would pass on to your tenant include the water/sewer bill, garbage, electric, gas, cable, lawn care/snow removal, etc. You may also have HOA fees. You must account for that fee if you hire a property manager to take care of your property.

Expenses Unaccounted for

Now, the following three “expenses” are three that most new investors don’t consider because you don’t shell out actual money every month for these. I would argue that they should always be part of your calculations when purchasing a property. Once you own it, they will help maintain a healthy bank balance.

Vacancy Rate

Vacancy rate refers to the time your property will be vacant (read: no tenant paying you). I would love to tell you that you will rent your property and never have anyone move out or that I can guarantee that you will always have one person moving out and another moving in the next day. These should be your goals, and there are ways to work towards them. But it would help if you counted on this not being the case every time.

The vacancy rate is calculated by dividing the number of days it is vacant by the total number of days you can rent it and multiplying by 100 to get your percentage.

So, how do you calculate this rate when you haven’t bought the property yet or have not rented it for an entire year? Vacancy rates can vary from area to area and investment type to investment type.

Source: ipropertymanagement.com

I quickly searched for national averages and found this chart from iPropertyManagement.com. As you can see, there can be significant differences between these states. Of course, real estate is local, so dig into your specific area.

That being said, a good rule of thumb is a 5%-8% vacancy rate. But here is a good tip: Take your time with the tenant screening process to keep this vacancy rate low! Proper screening ensures you don’t have another vacancy in the short run.

Repairs and Capital Expenditures (CapEx)

All properties require both at some point. Your CapEx includes significant expenses you should save up for, like a new roof, a new heater or AC, and other vital projects. Your repairs happen intermittently: a sprinkler gets broken, the sink starts leaking, a window won’t lock properly, etc. Since these can happen anytime, you should have some money in the piggy bank to get these items fixed. Thus, it would help to account for them in your expense calculation.

There are also average rates for these expenses, and I typically use 8% for each. If you have a brand-new house, you can get by with lower rates for these since the assumption is that everything is new and unlikely to fall apart anytime soon. Conversely, the older the home, the more I would put away for these items.

Calculating Cash Flow

So, what does all this look like in numbers?

Let’s say you wanted to buy this fourplex.

Source: intermountainmls.com

This is a converted fourplex — much like what you might find near downtown Nampa.

First, Some Hypothetical Numbers…

Purchase Price: $500,000

Down Payment: 25% = $125,000

Finance Amount: 375,000

Interest Rate: 7.5% (over 30 years)

Income Sources

Rents: 2/1 = $1250, 2/1 = $1100, 1/1 = $1100, 1/1 = $850

Total Rent: $4300/mo

Garage/storage: $30×3=$90/mo

12 X 15= $180/mo

10x 15 = $150/mo

Laundry: $60/mo ($5/wd x 3 loads/week x 4)

Total Income: $4450/mo

Expenses

PITI: $3006

Principal & Interest: $2622/mo

Taxes: $3400/12 = $284/mo

Insurance: $1200/12 = $100/mo

Operating costs passed on to tenant: Electricity, Water, Sewer, Trash, Phone, Cable, Lawn Maintenance

Vacancy rate expense: 5% = $222.50/mo = 18 days

Repairs/Maint: 8% = $356/mo

CapEx: 10% = $445/mo

Total Expenses: $4029.50

 

Income – Expenses = Cash Flow

$4450 – $4029.50 = $420.50/mo X 12 mo = $5046 per year

 

In this instance, you have a positive in your income column, which means you have positive cash flow. If you are looking for a property that will immediately put money into your pocket, this is a good one. But what if any of these numbers changed, and you found yourself with a negative number? Does that mean you shouldn’t invest? Is it a bad deal?

Well, that depends on your end goal and your financial situation. No one wants to supplement a property with their own money, but some people do.

In Conclusion

Cash flow is not the only measure investors consider when analyzing a property for long-term investment. There are other ways to determine if a property is a good investment for you or not.

Want to learn more about your real estate investment journey or how to run the numbers on your next investment? Contact us for a one-on-one conversation about your goals.

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